Project: Real exchange rate in China

Title: Determination of real exchange rate in China : a productivity approach

There is increasing evidence that exchange rate movements depend upon a country’s productivity growth (or stage of development), and this effect is dubbed the Balassa-Samuelson theorem. This paper examines the evidence for a Balassa-Samuelson based explanation for real exchange rate movements of China vis-a-vis the U.S. dollar. Using disaggregated industry level data, we construct sectoral total factor productivities (TFP) for the tradable and nontradable sectors in 1980-2003. Our main findings are: (a) the sectoral TFP differential is cointegrated with the relative price of nontradables with the unit cointegration vector; and (b) the real exchange rate is cointegrated with home and foreign sectoral TFP differentials. This productivity based real exchange rate model is then used to estimate the equilibrium exchange rate of the Chinese currency, Renrninbi. A comparison of the equilibrium exchange rate predicted by the productivity based model and the actual rate indicates that the Renminbi is somewhat undervalued against the US dollar, though the undervaluation is not statistically significant. This suggests that the extent of Renrninbi undervaluation has been exaggerated in the recent debate. Our conclusions continue to hold even after we have controlled for the movements of related fundamentals.

Author: Yip, Moon Wa

Source: City University of Hong Kong

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